Earnings season kicked into gear this past week and gave markets some fundamental data. The 2nd quarter for corporate earnings is going to be a bear, as analysts project earnings growth to drop more than 40% compared to the previous year. Of course, this is not news due to shutdowns and coronavirus-related fallout throughout the quarter. We are looking for surprises (hopefully to the upside), corporate guidance, and forward projections. The stock market recovery is putting a premium on forward earnings, with the S&P 500 1-year forward price to earnings ratio rising to 22.4. The other factor contributing to that run-up is fiscal and monetary stimulus. There is a rush to extend fiscal stimulus due to a brief Congressional session and CARES Act relief provisions coming to an end.
The 2nd quarter earnings season kicked off in earnest this week, and the outlook is particularly bleak. Per I/B/E/S data from Refinitiv, the estimated year-over-year earnings growth rate for the S&P 500 for Q2 2020 is -43.2%, while estimated year-over-year revenue growth rate is expected to be -10.9%.
From a sector standpoint, the companies that were under pressure in the 1st quarter are expected to continue to struggle. Specifically, energy and consumer discretionary sectors are expected to see earnings turn into losses, which weighs on the performance of the index in aggregate. If the energy sector is excluded, the growth rate improves to -37.7%.
Additionally, financials are expected to see earnings fall -51.7% year-over-year. There have already been 17 of the 66 financial companies in the S&P 500 that have reported, led by the big banks this past week. The story has been large allocations to loan loss provisions for expected loan defaults. JPMorgan increased its credit loss provision by $8.9 billion across its operations, Citigroup’s increased by $7.9 billion, and Bank of America’s rose by $4 billion. On a positive note, trading and investment banking activities all showed growth for the quarter to help offset the consumer and commercial lending struggles.
Although no sector is expected to see positive earnings growth this quarter, utilities, health care, and technology should hold up well on a relative basis. Those sectors are expected to see earnings growth of -4.5%, -8.8%, and -7.8% year-over-year, respectively.
With all of that said, this large contraction in 2nd quarter earnings is not a surprise, and investors should focus on guidance to gauge how efficiently companies can perform in a partially-opened economy.
When we are translating the language of economic data to stock market behavior, the trend tends to matter more than the level (i.e. better or worse rather than good or bad). And, from that standpoint, we are experiencing dramatically low earnings, but expectations are for the trend to improve. You can see in the chart below that estimates are indicating a sharp snapback in earnings growth in early 2021.
There are a couple of caveats to earnings estimates right now. Nearly 200 S&P 500 companies have withdrawn the forward guidance that they traditionally provide to analysts, and the spread between analysts’ lowest and highest estimates is historically wide. However, any forward-looking guidance from companies likely will still be the best indicator. Also, sell-side analysts still have to make assumptions about units sold, profit margins, expenses, net income, etc. Thus, through this process, the sell-side consensus gets pretty close to financial and business reality. It’s not always perfect, but the process has been in place and worked since the late 1970s.
The 2nd quarter is expected to be the worst quarter of financial results for the S&P 500 since 2008 per FactSet. However, the Federal Reserve’s liquidity programs in combination with fiscal stimulus (and another round of fiscal stimulus is expected before August 1st to mainstream America) have caused the markets to be fairly sanguine coming into this earnings season.
Congress has a short window to debate another round of fiscal stimulus (technically their 5th bill) before they head out of town for their August recess. A few of the coronavirus aid items provided in the CARES Act, including expanded federal unemployment benefits, are set to expire at the end of July, which drives up the tension and importance of getting a bill done.
The Trump administration and Senate Majority Leader Mitch McConnell have expressed that they want another relief bill, but with a price tag not exceeding $1 trillion. The Democrat-controlled House already approved additional measures worth $3.5 trillion, but Republicans (who have a Senate majority) oppose many of them.
Here are some of the major provisions winding down along with upcoming debates:
Expanded Federal Unemployment Benefits: The federal government added $600 per week to state-provided unemployment benefits under the CARES Act, the main coronavirus relief measure passed by Congress in March. Those extra benefits, which helped plug a hole in household cash flow, are due to run out in the final week of July. Republicans are concerned that the payments could and have deterred people from returning to their jobs and want some of the stimulus channeled into a “back-to-work bonus” instead. Treasury Secretary Steven Mnuchin has said the Trump administration wants to cap enhanced unemployment benefits in the next coronavirus package to make sure workers do not get benefits amounting to more than their former wages.
Large Business Aid: The federal government provided $25 billion in payroll support to U.S. passenger airlines to help them retain staff through the end of September, as well as offering loans worth a similar amount. The major carriers have already signaled that layoffs will likely start as soon as that program expires. This month, United Airlines notified 36,000 employees – approximately 45% of its U.S. workforce – that their jobs will be at risk starting in October.
Small Business Aid: The Payroll Protection Program (PPP) still has approximately $132 billion remaining of $659 billion that was funded. The deadline to apply for the small-business relief program has been extended until August 8th. The problem is that businesses have not been able to re-apply once their funds ran out. The CARES Act only provided for 2 ½ months’ worth of payroll, and small businesses including restaurants, bars, entertainment, and travel-related companies are still facing capacity constraints and shutdowns, which heavily impact revenues.
In addition to previous relief provisions, McConnell wants to focus on liability protections for businesses, schools, and other entities. And Democrats are pushing for new federal aid to state and local governments affected by the coronavirus, which Republicans have resisted.
The stakes are high, but as we mentioned last week, the fiscal cash flow is a necessity to help us continue to ford this coronavirus recession.
Have a great Sunday!
Timothy W. Ellis, Jr., CPA/PFS, CFP®
Senior Investment Strategist, Wealth Strategist